Sell the Slippery Slide in Crude

by Tyler Craig | September 20, 2012 12:40 pm

In the face of a docile market increasingly beloved by the bulls, oil has been getting trounced. Crude oil’s successful breach of $100 last Friday was short-lived as the bears quickly whipped up a selling frenzy that has now taken black gold down 9% to $91.

What’s perhaps most interesting about the bearish action in oil is the isolation. It’s as if crude has become deaf to the bullish drum that has continued to beat, keeping other risk-on related assets like stocks afloat for the past three trading sessions.

Historically, stocks and oil have exhibited a positive correlation. Like BFFs (that’s “best friends forever” for you non-hipsters), they pal around together. In other words, persistent weakness in oil typically seeps into stocks as well. Of course, the divergence between stocks and oil also could resolve itself in the other direction. Perhaps stocks stay afloat, thereby muting the amount of downside we’ll see in oil in the coming weeks.

Click to Enlarge Unsurprisingly, the slippery slide in crude has resulted in renewed demand for option contracts, driving implied volatility to interesting heights.

Since last Thursday, the CBOE Crude Oil Volatility Index (OVX) is up almost 11% to 36.6%. With the United States Oil Fund (NYSE:USO[1]) 20-day historical volatility still sitting at 23%, implied volatility is sitting at a 13-point premium. While it might not be the greatest disparity between the two, it’s much higher than the type of risk premium being paid for most stock options. Considering the CBOE Volatility Index (VIX) is close to plumbing new lows for the year, options on the S&P 500 Index are much cheaper in comparison.

Click to Enlarge Throw it all together, and you can make a much more compelling case for selling options on USO in the coming days versus most other ETFs.

If you believe the continued strength in stocks will save oil from a full-fledged downtrend, consider selling out-of-the-money puts. The more aggressive trader could sell the October 33 puts for 85 cents. The more conservative trader could sell the November 30 puts for 55 cents.

If you don’t have an opinion on direction but agree with the premise that options are overpriced here, consider entering a November strangle by selling the 30 puts along with the 38 calls for a total net credit around $1.12.

At the time of this writing Tyler Craig had no positions in any of the aforementioned securities.